Gushing cash

Under pressure, how will Big Oil spend its billions?

SAN FRANCISCO (MarketWatch) -- Awash in billion-dollar profits from one of the greatest energy bonanzas in history, Big Oil has a problem: How to spend it?

The choices are many. They can give it to shareholders, spend it upgrading a teetering infrastructure, or snap up rivals in a headlong rush to secure more of the stuff that's making them so rich. Or they can float their senior executives into unfathomable wealth and ignore the howls of a seething public.

Meanwhile, investors want to hear whether the Exxons and Chevrons of the world have a gameplan to deflect a legislative assault on the industry and keep their money gainfully employed.

"The companies are going to invest what they need to and any excess money is going to go right to the shareholders," said Nick Cacchione, co-director of research at John S. Herold, an oil industry research company. "That trend is going to continue as long as prices remain high."

The numbers are staggering. The nation's top three oil companies - Exxon Mobil Corp.
XOM, -1.56%
Chevron Corp.
CVX, -0.86%
and ConocoPhillips
COP, -1.58%
reported this week a combined net profit of more than $15 billion in the first quarter driven by record-high oil prices that show little sign of letting up soon. Just this month, crude oil futures in New York hit $75 a barrel, raising speculation that $100 oil might not be so far-fetched anymore.

At the same time, gasoline prices in much of the nation are back up at $3 a gallon, a level not seen since Hurricane Katrina clobbered production platforms and refineries in the Gulf of Mexico, exposing the shortcomings of supply chains, refineries and distribution systems no longer keeping pace with demand.

"You have to remember that they are coming off a 20-year bear market. It was a big benefit to consumers, but pretty ugly for the oil companies," said Marshall Adkins, an industry analyst with Raymond James in Houston.

The great bear oil market was born in the mid-1980s, when Saudi Arabia, in a bid to defend market share from upstart producers, flooded the market with crude, sending prices from $35 a barrel to $10 and paving the way for a generation of cheap oil, big cars, and a booming, fossil-fuel-driven economy.

But the good times came at a cost.

Fixing what's broke

"During that time, the energy infrastructure deteriorated. The oil companies took on more debt, became more leveraged. But that's reversed over the past five years. For the first time ever, global oil demand caught up with supply and that line was crossed. That's why you're seeing oil prices where they are today," Adkins said.

With a steadily rising tide of cash flowing in, the first order of business has been for them to improve their balance sheets by paying down debt. According to data from researcher John S. Herold, the top three U.S. companies have done just that. From 2002 to 2005, Exxon Mobil, Chevron and ConocoPhillips' aggregate debt has dropped 20% from $36.7 billion to $29.2 billion.

After easing their debt load, Adkins said the industry's next step has been to pump money into the supply chain -- from the wellhead to the refinery terminal. Industry critics have howled over the lack of investment in this crucial area, accusing the industry of chronically neglecting capital expenditures when oil was cheap and profits meager.

The industry flatly denies charges of neglect, but admits that the pace has quickened as prices rise and cash is less of a problem.

"We have been investing steadily in the industry and expect to invest $20 billion a year over the next five years," said Exxon Mobil spokesman Dave Gardner. Last year alone, Exxon's cap spending hit $17.7 billion. But that's still less than half of the company's record-high $36.1 billion net profit.

Chevron said it plans to spend $14.8 billion this year, up 35% from the $11 billion it forked out in 2005, close to its total profit of $14.1 billion. On the other hand, it needs to spend more than Exxon to bolster flagging reserves.

The payoff

So where it the rest going? While ex-Exxon Mobil CEO Lee Raymond just left the company with a tidy $400 million retirement nest egg, shareholders are finding some trickle-down into their pockets as well.

"It's just the last few years that cashflow has been so great that they could reward investors, who haven't had a lot to cheer about in the last 10 to 15 years," said Cacchione.

"But we see them giving more back more to shareholders now, a trend we expect to continue. Interest expenses are tax deductible. It doesn't make sense for them to get all their debt off the books. So it makes more sense to repurchase shares or pay a bigger dividend," he added.

The trend has already been established. In 2003, Exxon Mobil bought back $4.8 billion worth of common shares on the open market, Chevron's purchases totaled only $3 million, and ConocoPhillips bought none. Last year, repurchases by the three totaled $22.7 billion, with Exxon accounting for the lion's share at $18.2 billion.

Likewise, Big Oil is paying fatter dividends than just a few years ago. According to John S. Herold data, payouts to shareholders for the three companies has increased 26% from just under $10 billion in 2003 to $12.6 billion in 2005.

With shareholders feeling a bit better about their investments, analysts said the oil companies can turn their attention to acquisitions. For some, they may have no choice.

The industry is scrambling to secure reserves at a clip that keep pace with ever-increasing demand. That means exploration and development costs are tying up more capital, partly the result of capacity lost during the lean years. Drilling rigs, for example, are in tight supply around the world and their owners are charging oil companies huge sums to lease them.

A basic land-based rig in North America now fetches $18,000 a day, twice the $9,000 day rate of just a year ago. The giant semi-submersible rigs used around the world for deepwater drilling have seen their day rates soar from $150,000 to $500,000 over the same period.

M&A allure

The exploration boom has also run into a shortage of trained engineers and service personnel in such diverse activities as rig construction and reservoir geology.

"The challenge is to ramp up exploration and production. There are constraints in the industry every step of the way," said Adkins.

Which means buying proven reserves is often a cheaper and almost always quicker way of replenishing dwindling reserves. Two blockbuster deals last year bear witness to the trend: Chevron's $17.3 billion purchase of Unocal and ConocoPhillips' $35.6 billion acquisition of Burlington Resources.

Worldwide, mergers and acquisitions in the oil patch doubled last year to $160 billion, the highest level seen since 1998, the year Exxon and Mobil decided to join forces. And with the biggest companies facing severe challenges to their growth, including challenges from fast-growing India and China, the stakes are likely to go even higher in 2006-2007.

"There's certainly a lot of cash floating around the majors now. As for acquisitions, any company except for these largest ones could be on someone's takeover list," Cacchione said.

Oil and gas companies looking to acquire reserves are showing a preference for non-conventional reserves, like oil sands and fields containing heavy grades of crude that are typically harder to bring to the surface and more costly to refine.

Industry analysts also point companies' growing willingness to buy "probable" and "possible" reserves instead of the "proven" reserves found and tapped by someone else, another sign that the influx of petrodollars is slowly increasing Big Oil's appetite for risk after two decades of entrenched risk-aversion among its top executives.

Intraday Data provided by SIX Financial Information and subject to terms of use.
Historical and current end-of-day data provided by SIX Financial Information.
All quotes are in local exchange time. Real-time last sale data for U.S. stock quotes reflect trades reported through Nasdaq only.
Intraday data delayed at least 15 minutes or per exchange requirements.